Monthly Archives: March 2015

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SEC Commissioner Daniel Gallagher delivered remarks at the Vanderbilt Law School’s 17th Annual Law and Business Conference. He spoke about what he called the “critical capital formation issues” faced by the SEC.

Commissioner Gallagher stated that while he is pleased with the SEC’s recent adoption of changes to Regulation A+ (“Reg. A”), the rule is “not as good as it could have been.” He encouraged companies to ensure Reg. A’s success by reporting any inefficiencies in the regulatory scheme as they began to use the new rules to raise capital. He also stated that while the revisions to Reg. A “were targeted at enhancing the primary issuance of securities,” the SEC’s enhancement of secondary market liquidity for these shares through venture exchanges could reinvigorate Reg. A even more.

Additionally, Commissioner Gallagher explained that Reg. A does little to help facilitate capital formation for an issuer looking to raise $5 million or less. After mentioning Regulation D’s facilitation of crowdfunding as a possible solution to capital formation for smaller companies provided in Rule 506 of Regulation D, he discussed the Rule 504 and 505 exemptions, which permit capital raises of up to $1 million and $5 million, respectively. According to Commissioner Gallagher, the fact that these rules are used infrequently is “directly attributable to the lack of state law preemption.” He stated that the SEC should consider preempting state blue sky laws, raising the offering caps, and expanding the availability of general solicitation in these rules. He also said that it might be time to explore other ways to balance access to capital and investor protection, and to give issuers other choices when raising capital.

Commissioner Gallagher also said that it is impossible for smaller start-ups to comply with the reporting expected of the largest companies. He explained that the SEC should “further segment our small companies into bands” based on commonly used market definitions of “nanocap” and “microcap,” and scale back reporting requirements more radically for the smallest issuers. He expressed his hope that the Division of Corporation Finance would come out with an “aggressive agenda” for disclosure simplification, and that the SEC would perform more rigorous cost-benefit analyses of any new rules.

Lofchie Comment: Stimulating economic growth could take some amount of regulatory loosening, which might involve some risk of wrongdoing. On the other hand, continuing on our current course of growth presents different long-term risks. Which way will the SEC and state governments go?

Board of Governors of the Federal Reserve System (“FRB”) Vice Chair Stanley Fischer delivered remarks on the importance of the non-bank financial sector at the Debt and Financial Stability – Regulatory Challenges conference.

Mr. Fischer described how non-bank intermediation in the United States has changed, as well as non-bank financial institutions’ role in the financial crisis. He explained that the growth of the non-bank sector has increased the complexity of the financial system and lengthened intermediation chains. Additionally, according to Mr. Fischer, non-banks “increase the amount of maturity transformation conducted in the financial system without the stability-enhancing backstops offered to banks.”

Mr. Fischer also explained that a variety of reforms have helped address risks in the non-bank financial sector, such as the creation of the Financial Stability Oversight Council (“FSOC”), the SEC’s adoption of new rules for money market mutual funds, and a new rule regarding securitization. He stated that while “there are signs of reduced non-bank financial sector vulnerabilities,” there are areas that require continued work, including:

short-term wholesale funding markets – Mr. Fischer stated that there are many non-bank financial firms that continue to rely on secured short-term funding to finance their activities, many of which involve longer-term and illiquid assets;

areas of the non-bank sector that are not subject to prudential supervision, such as the asset management industry; and

gaining better data coverage on certain areas of the non-bank financial system, such as the hedge fund industry.

Lofchie Comment: Notwithstanding Governor Fischer’s learned and moderate point of view, the underlying suggestion is arguably quite radical: that the federal government, acting either through the Board of Governors or through the FSOC, should have much greater control over the investment and funding decisions made by private investors; i.e., the “asset management industry.” Nor is Mr. Fischer the only member of the Federal Reserve to so indicate that governmental control over private investment decisions should be increased: see, e.g., Governor Tarullo’s speech on Macroprudential Regulation.

It is obvious that Dodd-Frank magnified by many times the power of the government with respect to the financial sector; while one can debate whether that is all to the good, there is certainly no doubt that an increase in governmental power was intended. It is not at all clear to me that Congress intended the type of increase in governmental power suggested by Governors Fischer and Tarullo. What they suggest goes far beyond regulating financial intermediaries; they suggest governmental control of private investment decisions.

As to the suggestion by the FSOC, to which Governor Fischer refers, that asset managers could be “systemically significant” – that seems so outlandish on its face as to not be serious. But there is a more serious issue that has been raised by creation of the FSOC: that the FSOC could determine that asset managers as a group make decisions that are not optimal for the economy as a whole, perhaps because they invest in too similar a manner. (By way of example, here is a key take-away from the report of the Office of Financial Research (“OFR”) on the asset management industry (at page 10): “[Existing] regulation [of asset managers] focuses on helping ensure that managers adhere to their clients’ desired risk-return profiles, but does not always address collective action problems and other broader behavioral issues that can contribute to asset price bubbles or other market cycles.”) One can readily concede to the truth of this OFR/FSOC observation: it is the nature of a free, capitalist economy that individual investors make investment decisions that are not dictated by the government, even if some government agency might determine that some other set of investment decisions, taken as a whole, would be preferable.

Of course, the government has many ways to influence private investment decisions; e.g., by altering tax rates, tax deductions, governmental subsidies, the money supply, borrowings through the Federal Reserve Bank of New York, and so on. There is certainly room for debate as to which measures are appropriate and effective, but moving beyond those “traditional” exercises of government power to the actual dictation of investment decisions and financing decisions made by private parties should not be viewed as ordinary course.

The Bill would amend the Securities Exchange Act of 1934 (the “Exchange Act”) by adding a new Section 16A to include language that would, among other things, make it expressly “unlawful for any person, directly or indirectly, to purchase, sell, or enter into, or cause the purchase” of any financial product while in possession of material nonpublic information relating to the financial product.

The Bill also prohibits trading on nonpublic information if such a trader “knows, or recklessly disregards” that such information has been obtained wrongfully, or that such purchase, sale or entry would “constitute a wrongful use of such information.” Additionally, the Bill contains a “Standard and Knowledge Requirement” that specifies the ways in which the nonpublic information may be obtained and communicated.

The Bill has been referred to the House Committee on Financial Services.

Previously, the Senate proposed its own version of a bill to define insider trading: the “Stop Illegal Insider Trading Act” (S. 702). As of March 11, 2015, the S. 702 bill has been read twice and referred to the Senate Committee on Banking, Housing and Urban Affairs.

Lofchie Comment: The House version of the bill seeking to expand the scope of the insider trading prohibition is more precisely drafted than the Senate version. In the Senate version, liability for insider trading is predicated on information being obtained from sources other than “publicly available sources”; however, that apparent term itself was not defined, nor is it obvious that a source of information that is not otherwise publicly available is, or should be, an inherently illegal source. By contrast, in the House version of the bill, liability is predicated on the fact that the information was “wrongfully obtained or communicated,” thus basing liability under the bill on a violation of existing law. The House version of the bill also is more extensive in its consideration of when an entity may be liable for the conduct of its employees, and when an agent may rely on the authority of its principal.

Although the Senate version contains a provision allowing the SEC to grant exemptions from the prohibition in the bill, this provision should not be necessary, since the SEC generally has exemptive authority under Section 36 of the Securities Exchange Act and thus does not require particular authority with regard to this provision.

The Federal Reserve Bank of New York issued a preliminary staff paper, titled “Does Central Clearing Reduce Counterparty Risk in Realistic Financial Networks?” authored by Rodney Garratt and Peter Zimmerman. The paper examines the effect of introducing a central clearing counterparty (“CCP”) on the expected net exposures of dealers, and also explores the effect of such introductions on the variance of these net exposures.

The authors find that a CCP is unlikely to be beneficial when the link structure of the network relies on just a few key nodes. In large scale-free networks in particular, a CCP will “always worsen” expected netting efficiency. Additionally, the authors find that CCPs can improve netting efficiency only if agents have some degree of risk aversion that allows them to trade off the reduced variance against higher expected netted exposures.

Consequently, when the number of asset classes is small in relation to the number of dealers, introducing a CCP is likely to reduce both the mean and the variance of net exposures. The authors speculate that this may explain why, in the absence of regulation, traders in a derivatives network may not develop a CCP themselves. For smaller core-periphery networks, the authors found that a critical size exists beyond which introducing a CCP is unambiguously good for netting efficiency.

Lofchie Comment: Despite the complexity of the math, or because of it, the authors thoroughly debunk the myth that central clearinghouses reduce risk. One problem with clearinghouses that the mathematicians ignore is this: because CCPs have the power to demand unlimited collateral from their clearing members, CCPs will drain liquidity from the financial markets in times of financial crisis. That is, the biggest risk is not that CCPs will fail; it is that they will survive by demanding so much collateral that they crash the rest of the market.

The SEC proposed rule amendments to Exchange Act Rule 15b9-1 to require broker-dealers trading in off-exchange venues to become members of a national securities association (i.e., FINRA). According to the SEC, the amendments would enhance the regulatory oversight of active proprietary trading firms, such as high-frequency traders.

Currently, Rule 15b9-1 exempts certain brokers-dealers from membership in FINRA if they (i) are members of a national securities exchange, (ii) carry no customer accounts, and (iii) each have annual gross incomes in which no more than $1,000 is derived from securities transactions effected somewhere other than on a national securities exchange of which they are members. Income derived from proprietary trading conducted with or through another broker-dealer does not count against the $1,000 limit.

According to the SEC, many active cross-market proprietary trading firms have emerged that are not members of FINRA because they have been able to rely on the broad proprietary trading exemption in Rule 15b9-1.

The proposal would amend the Rule 15b9-1 exemption to target the broker-dealers for which it was originally designed by eliminating the current proprietary trading exemption and replacing it with a “more focused one” that would accommodate off-exchange transactions by floor-based dealers that are effected solely for the purpose of hedging the risks of the dealers’ floor-based activities. The amendments also would update the exemption that permits the off-exchange transactions that are necessary to comply with regulatory requirements restricting trade-throughs under Rule 611 of Regulation NMS.

The SEC Commissioners generally voiced support for the proposal, but some of them expressed concerns. Commissioner Gallagher stated that he is “not convinced that proprietary dealers that avail themselves of the current exemption are a threat to investors or the market.” Similarly, Commissioner Piwowar commented that he is not sure why the proposal is necessary and appropriate. Commissioner Piwowar also voiced his concern that the proposal might impose too many conditions on the exemption.

Commissioner Piwowar also wondered aloud whether FINRA could use the increased fee revenue that will be generated by an influx of membership “in a manner that would not translate to better regulatory oversight for the new members.”

Lofchie Comment: As membership in FINRA becomes a near-universal requirement for broker-dealers, the most interesting question to emerge is not whether all broker-dealers should be required to become FINRA members, but whether FINRA should be considered a government actor.

Office of Financial Research (“OFR”) Director Richard Berner gave a speech at the Financial Regulation Summit. His remarks concerned the ways in which the development of standards can improve financial data and transparency.

According to Director Berner, gaps in analysis, data and policy tools can lead to the inability to address weaknesses in the financial system. He explained that standards, such as the global legal entity identifier (“LEI”), are needed to produce high-quality data, and added that the OFR has asked regulators to require a broader use of the LEI in regulatory reporting, as well as the broad adoption of standards for instruments and products as they become available.

Additionally, Director Berner announced that the OFR is developing plans for a reference database for financial instruments. He stated that this database should not compete with those of private firms, nonprofits and academic institutions; rather, these other products should be included in the OFR database’s design so that all of the systems can work together.

Director Berner also mentioned that the OFR entered into a partnership with the Board of Governors of the Federal Reserve System to fill gaps in data that describe repurchase agreements. For the first time, he said, the OFR is going directly to the industry to collect financial market information, and the results will be evident in this collaborative project.

Lofchie Comment: At some point, the demand for information from multiple government entities becomes a drag on the economy. It’s a variation on the Heisenberg Uncertainty Principle (the more precisely the position of some particle is determined, the less precisely its momentum can be known); i.e., the more substantial the energy expended to report on work that has been done, the less substantial the work that can be done. Perhaps this phenomenon should be named the “Watched-Pot Analytic Syndrome.”

Chair White outlined the SEC’s regulatory accomplishments and highlighted the work of each of the SEC’s divisions and offices, and noted the ways in which the SEC has made progress in implementing the Dodd-Frank and JOBS Acts.

Notably, Chair White stated that the SEC’s review of equity market structure continued to progress with a “data-driven approach” that helped to identify areas where improvement is needed. She outlined a series of rulemaking initiatives on which the SEC plans to focus in the upcoming year, which include:

a rule proposal, scheduled to be considered on March 25, that would eliminate an exemption from national securities association membership requirements for broker-dealers that trade in off-exchange venues;

rules designed to improve firms’ risk management of trading algorithms and to enhance regulatory oversight of their use;

rules that would expand the information that alternative trading systems (“ATSs”) disclose to the SEC about their operations and make ATSs’ operational information publicly available for the first time;

an order-routing transparency rule that would require the disclosure of customer-specific information that a broker is expected to provide to institutional customers on request;

an anti-disruptive trading rule to address the use of aggressive, destabilizing trading strategies in vulnerable market conditions when they could exacerbate price volatility the most; and

a rule regarding the status of active proprietary traders as dealers.

Chair White also addressed the implementation of a fiduciary duty standard, stating that “broker-dealers and investment advisers should be subject to a uniform fiduciary standard of conduct when providing personalized securities advice to retail investors.” She identified three main challenges in proposing a uniform standard: (i) defining a standard that is codified, principles-based and rooted in the fiduciary duty applicable to investment advisers; (ii) providing clear guidance on what the standard would require; and (iii) allowing for the meaningful application, examination and consistent enforcement of the standard.

On a different note, Chair White observed that the SEC has provided the Department of Labor (“DOL”) with “technical assistance” regarding its potential changes to the definition of “fiduciary” under ERISA. She reiterated the SEC’s commitment to working with the DOL by providing assistance and information involving the best “regulatory” approach, including the projected effect on retail investors of any potential amendments.

Finally, Chair White explained that the SEC’s FY 2016 budget request of $1.722 billion is necessary in order to maintain its responsibilities given the growing size and complexity of the securities market. The SEC’s budget will be dedicated to the following “key” areas:

bolstering examination coverage for investment advisers;

focusing on economic risk analysis to support rulemaking and oversight;

meeting its expanded responsibilities for overseeing the securities markets and key participants in those markets; and

The article highlights how CFS data on market finance or “shadow banking” can measure the durability of the recovery and help frame the policy debate in a balanced way.

A few highlights include:

“Seven years after the financial crisis, lending in the so-called shadow-banking system finally appears to have bottomed out, a reversal that could presage a long-awaited uptick in U.S. economic growth.”

“Extrapolations from CFS data show that the level of market finance is significantly below where its post-1967 trend would predict. In other words, a great deal of expansion is needed to bring this market back even to a level projected by its prebubble state. Until then, shadow banking will continue to do far less of the heavy lifting in credit creation than it used to.”

For the full article “Shadow-Credit Rise Is Good Sign,” please see page C3 of this morning’s paper or view http://www.wsj.com/articles/shadow-credit-rise-is-good-sign-1427071556.

SEC Commissioner Luis Aguilar asserted that “fundamental” challenges face the SEC. He stated that these challenges “cut across several important regulatory responsibilities, and demonstrate the need for the Commission to evolve and adapt to changing times.” The Commissioner delivered his remarks before a Georgia Law Review Symposium titled “Financial Regulation: Reflections and Projections” held at the University of Georgia.

According to Commissioner Aguilar, the two major challenges facing the SEC are: (i) the use of its data and technology, and (ii) the increasingly interconnected nature of the global economy. Regarding the first challenge, he explained that while the SEC has made efforts to evolve into a more informed regulator through various data gathering and technology driven initiatives, the agency is still “struggling to keep up” with market and technological developments.

Commissioner Aguilar noted some recent efforts to address this issue, such as the Consolidated Audit Trail as well as a data tagging requirement. He stated, however, that the SEC must push forward with its efforts to embed interactive data into more of its regulatory filing requirements. He asserted that Congress should provide the SEC with the proper funding to utilize “cutting-edge technologies” and hire staff to analyze data, assess risk, conduct examinations, and detect and investigate fraud.

Regarding the globalization of securities regulation, Commissioner Aguilar stated that to protect American investors the SEC will have to “increase its efforts to communicate, coordinate, and cooperate with its international counterparts.” An important aspect of globalization is addressing cross-border fraud, and he stated that recent statistics “underscore the growing need for mutual cooperation in cross-border enforcement.” As companies increasingly have non-U.S. operations, the SEC must consider: (i) what it can do to prevent, detect, and mitigate the domestic impact of fraud originating from a foreign jurisdiction, and (ii) what it can do to foster global efforts to combat fraud and enhance market integrity.

Lofchie Comment: Much of the Commissioner’s speech focuses on the SEC’s need for more/better/quicker data. In this regard, his speech could have been delivered by numerous other securities regulators, banking regulators or the CEA. Whether the regulators actually need all of this information is an issue rarely analyzed. Regulated entities are becoming overwhelmed by increasingly demanding information requirements from an increasing number of regulators. Accordingly, it would be an improvement for the regulators to collectively analyze and aggregate their information needs, and consider how these can be fulfilled on a reasonable and coordinated schedule.

As part of any such information request, regulators should consider what use they get out of the information they now collect, and whether their process for determining what information is useful actually works. Many of the current information requests provide no discernible benefit (see Form PF). A process providing ongoing consideration of the value of the information collected would spur productive discussion as to just what information might be useful and for what purposes.

Oxfam America Inc. (“Oxfam”), an anti-poverty group, submitted a memorandum in reply to the SEC’s summary judgment opposition. In the memorandum, Oxfam asks the U.S. District Court for the District of Massachusetts to reject the SEC’s contention that a Dodd-Frank rule requiring oil, gas and mineral companies to report payments to foreign governments would be too complex to finish this year.

The Oxfam suit, filed in September 2014, seeks to compel the agency to implement Section 1504 of Dodd-Frank.

According to the memorandum, the SEC’s argument against the enforcement of the mandate takes two forms: (i) that the SEC “is busy,” and (ii) that the SEC “has already tried, but failed, to meet that mandate.” According to Oxfam, “neither agency convenience nor agency preference percolates upwards to nullify a statutory command.”

Oxfam stated that the issues raised by the rulemaking are “not particularly complex,” and that the SEC “overstates the task before it.” Additionally, Oxfam said that by failing to meet the Congressional deadline for a rulemaking, the SEC is in violation of Section 706(1) of the Administrative Procedure Act.

Oxfam requested that the court grant a summary judgment in favor of Oxfam and enter an order requiring the SEC to (i) issue a proposed rule within 30 days of the issuance of the summary judgment or on August 1, 2015, (ii) open a 45-day period for public notice and comment, and (iii) promulgate a final rule within 45 days after the end of this period, no later than November 1, 2015.

Lofchie Comment: Congress habitually requires the SEC and other agencies to adopt rules that have timetables that are impossible to meet. For example, most Dodd-Frank deadlines fit in this category. It is hard to imagine on what basis a court could require the SEC to proceed with the adoption of this particular rule when so many other rules are well past their legislative “deadlines.”